Coinbase, one of the largest crypto exchanges, has been embroiled in litigation for some time with the US Securities and Exchange Commission (SEC), trying to force the SEC into rule-making as well as more recently making public documents revealing how US banking regulators have made "suggestions" that US banks avoid servicing crypto or getting involved in crypto related product offerings.
In a ruling from their recent appeal, Coinbase has had a significant victory with the SEC's actions being found "arbitrary and capricious", but stopped short (dare we say "rugged Coinbase") in not ordering the SEC to institute rule-making for crypto, but instead to provide more detailed reasons for the rejection.
The Case History
Coinbase, facing uncertainties around the rules for crypto issuances in the USA, and with the SEC alleging tokens are securities without setting out any basis by which that was determined (other than saying the token offerings had met the Howey test), petitioned the SEC asking that they promulgate rules clarifying how and when US federal securities laws would apply to digital assets.
Following litigation, the SEC was ordered to respond and then denied the rulemaking petition and gave a single paragraph saying it had higher-priority agenda items, and it might prefer to take an incremental approach.
The Court recounted the SEC's approach to digital assets, including:
The DAO Report, in which the SEC stated the DAO tokens easily satisfied the Howey test because "the DAO raised money by exchanging ether for special-purpose tokens, and those tokens promised future profits resulting from projects undertaken by the DAO". The Court noted that "The DAO Report did not provide a precise formula for determining when a digital asset is a security."
In 2019 the SEC issued a Framework for 'Investment Contract' Analysis of Digital Assets in which again the SEC said issuers "will need to analyze the relevant transactions to determine if the federal securities laws apply"
Various comments by SEC Commissioners concerning digital assets including:
In 2018 William Hinman's statement that a digital asset "all by itself is not a security".
In 2021 Gary Gensler's testimony in Congress that “only Congress … could really address … bring[ing] greater investor protection to the crypto exchanges."
In 2021 Mr Gensler's speech to the Aspen Security Forum that '“[t]here’s actually a lot of clarity” about whether existing securities laws apply to digital assets.'
In 2022 Mr Gensler's comment to a reporter that the SEC "ha[s] enough authority … in this Case: 23-3202 Document: 60 Page: 10 Date Filed: 01/13/2025 11 space”
In 2023, Mr Gensler saying that "the vast majority of crypto assets likely meet the investment contract test, making them subject to the securities laws"
The SEC expanded their enforcement agenda to digital assets in 2023 and the Court noted an action against Coinbase, with an allegation that Coinbase was an unregistered broker, exchange and clearinghouse.
Coinbase Petition
In July 2022 Coinbase filed a rulemaking petition with the SEC urging that they adopt new rules for reasons including that:
the securities-law framework was "fundamentally incompatible with the operation of digital asset securities"
Digital assets possess non-investment uses including for paying transactions/gas fees, voting and being a medium of exchange for native applications.
Blockchains, as decentralised networks, often have no one who can register or make required disclosures.
Existing laws do not provide owners of digital assets with useful information because they are designed for issuers of traditional equity and debt securities and "poorly fit the decentralised and open-source nature of blockchain based digital asset securities".
Custody rules don't include provision for private keys.
The "Net capital Rule" could require companies holding custody of digital assets to "contribute a dollar of cash as additional equity...for every dollar worth of digital asset security custodied" which would be "non-economic and unsustainable".
Nine months after petitioning the SEC, Coinbase sued seeking a writ of mandamus, that is an order that the government agency do something which it has failed to do.
In June 2023 the Court ordered that the SEC provide an update on the status of the rulemaking petition by October 2023, and the SEC informed the court that its staff had made a recommendation but the Commissioners had not made a final decision. In December 2023 the SEC denied the rule-making petition with only a single paragraph of reasoning.
Reasoning
Coinbase argued the SEC's rejection was arbitrary and capricious on three grounds:
1) the decision to apply securities laws to digital assets is a "significant policy change" that "presumptively" requires rulemaking;
2) the emergence of digital assets changes a fundamental fact underlying the entire existing regulatory framework - specifically that compliance is possible at all.
3) that the SEC's explanation was conclusory and insufficiently reasoned.
In considering the matter, the Court commented on a sensible point made by Coinbase that:
whether a crypto asset implicates the ... securities laws depends on the facts and circumstances of its offer and sale”—is a “truism” and thus “no test at all.” In Coinbase’s view, the relevant question for purposes of fair notice is not “whether the securities laws can apply to certain digital asset transactions, but rather how and to what extent they apply.
The Court statwr that if a particular enforcement action violates administrative-law, the proper approach would be to move to dismiss that enforcement action.
The Court also did not accept an argument that compliance with existing laws being impossible, the SEC ought to rule-make instead of conduct enforcement, saying:
law often works by regulating or even prohibiting conduct that some would like to pursue
Finding
The Court considered the SEC's three reasons in the denial of the rule-making petition:
1) That the SEC disagreed with the assertion that existing securities laws were unworkable;
2) That consideration of how to alter the regime could be informed by data and information relating to current enforcement, and be incremental); and
3) That the SEC has many other priorities.
The Court agreed these were inadequate, noting that:
A single sentence disagreeing with the main concerns of a rulemaking petition is conclusory and does not provide us with any assurance that the SEC considered Coinbase’s workability objections, nor does it explain how it accounted for them.
The Court criticized what the SEC had said about resource allocation, saying it must do more than claim it has other priorities, and that "at a minimum, it must explain why it is prioritizing other regulatory actions". Similarly the suggestion that the SEC might prefer to move incrementally needed to be explained in much more detail, but the SEC's explanation was "conclusory".
The concurring opinion by Justice Bibas offers an analysis of the tensions between existing securities regulations and the novel aspects of blockchain technology and crypto assets.
Some great quotes from this opinion include:
Nearly a century ago, Congress created the SEC to serve as a watchdog for securities markets, including by developing rules. The SEC insists that its old rules apply to the novel crypto market but refuses to spell out how.
old regulations fit poorly with this new technology, and its enforcement strategy raises constitutional notice concerns.
...some crypto assets could be securities in infancy and something else in adulthood. But...classifying them as securities could strangle them in their cribs.
At oral argument in this very case, the SEC’s lawyer refused to say whether Bitcoin and Ether are securities... [t]hat evasivenessis puzzling.
The SEC repeatedly sues crypto companies for not complying with the law, yet it will not tell them how to comply. That caginess creates a serious constitutional problem; due process guarantees fair notice...
No victims are evident, yet the agency keeps seeking penalties. It targets not just fraudsters, but also the infrastructure on which much of the crypto industry relies.
Finding and Remedy
As such, the Court found for Coinbase, but did not go so far as to order the SEC to engage in rule-making, as that would only occur in "the rarest and most compelling of circumstances" and instead ordered that the SEC provide a sufficiently reasoned rejection of Coinbase's petition, with Justice Bibas saying firmly:
We properly remand to the SEC to explain itself; it should not give yet another poor explanation in an already-long line of them
What does this mean?
Now the SEC must come up with a much lengthier and better reasoned basis for it's rejection of Coinbase's petition for rule-making.
It would seem that all the effort and money spent on this litigation could have funded sensible rule-making by the SEC (possibly several times over) but given the overt hostility the SEC has shown towards the cryptocurrency sector, we would expect the SEC to simply follow the orders of the court and provide more detail for its reason, and Coinbase may again seek to appeal that if they are dissatisfied with the outcome. It remains to be seen whether personnel changes at the SEC following the Trump inauguration will impact the SEC’s approach in dealing with the matter.
If all this seems a bit academic, it is worth remembering that administrative law, the body of law that deals with whether government agencies are doing their jobs, is inherently focused on the process and is not usually an inquiry into what the outcome of an agency's decision should be. Government agencies are granted great discretion in applying their limited resources to different priorities, and Courts have historically given a great deal of deference to that discretion.
By Michael Bacina and Steven Pettigrove
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